This invention relates generally to financial services and products, and more particularly to a multi-basket structure for exchange-traded funds (ETFs) and other similar investment vehicles.
Exchange-traded funds, or ETFs, are securities that represent a legal right of ownership over an underlying portfolio of securities or other assets held by the issuing fund. The assets held in an ETF may include individual stocks, bonds, cash, commodities, derivatives, or any tradable asset, including contracts based on the value of any of the foregoing. Shares of an ETF are designed to be listed on a securities exchange and traded over the exchange just like other securities. ETFs thus allow an investor to own a set or “basket” of assets by simply purchasing shares in the individual ETF. Many existing ETFs hold a mix of assets that aim to replicate or otherwise match the characteristics of a particular published index. These ETFs allow investors to get exposure to the particular index by purchasing shares of the single ETF. Because of their low cost and tax advantages, ETFs have grown in popularity in recent years.
An ETF is a type of regulated investment fund with characteristics of both an index mutual fund and a closed-end fund. An ETF resembles an index mutual fund in that an ETF generally holds a basket of securities designed to replicate the returns of a securities index, has lower fees than comparable actively-managed mutual funds, and is required to permit daily redemptions at the current value of its holdings. An ETF resembles a closed-end fund in that its shares trade on an exchange throughout the trading day and most investors buy and sell shares on the exchange (rather than direct purchases and redemptions from the fund itself, as is the case with mutual funds). Until recently, the only ETFs approved by the Securities and Exchange Commission (SEC) have been index-based strategies. The SEC has more recently approved the first active (i.e., actively-managed) ETFs; however, these active ETFs must disclose the ETF's portfolio holdings daily.
As the Wall Street Journal has written, “ETFs generally have lower expenses than traditional mutual funds (including index funds), and they trade throughout the day on an exchange, while mutual funds' price are set just once daily. They're also markedly more tax-efficient than mutual funds, and investors know exactly what they're buying because holdings are completely transparent.” Unlike mutual funds, most transactions in ETF shares are conducted in the secondary market (i.e., on an exchange) and do not involve the movement of assets in or out of the fund. In the case of transactions in creation units that do involve the movement of assets into or out of the fund, the transactions are routinely effected by giving the redeeming shareholder its pro rata share of the fund's holdings, which does not impose trading costs or adverse tax consequences on the remaining shareholders.
ETFs have two types of investors: large, institutional, sophisticated trading desks, known as “Authorized Participants,” that transact directly with the ETF, and everybody else. All investors, including Authorized Participants, can buy and sell shares of an ETF on an exchange throughout the trading day, like a stock, including the ability to sell shares “short.” In addition, Authorized Participants can purchase or redeem shares from the ETF at the current value of the ETF's holdings at the end of each trading day, but must do so in large blocks of shares (sometimes referred to as “creation units”). Purchases and redemptions of creation units are typically done by means of the Authorized Participant and the ETF exchanging ETF shares for a block of the ETF's underlying holdings having a value equal to the ETF shares. This has the effect of low fees and low trading costs associated with ETFs. Because ETFs deal directly only with a few dozen Authorized Participants, their administrative costs are lower than is typical for mutual funds. The administrative savings are generally passed on to ETF shareholders through low fees. In addition, because ETFs transact with Authorized Participants in kind by exchanging ETF shares for fund holdings, or vice versa, they do not need to buy or sell securities in response to daily cash flows like a mutual fund. Instead, the costs of buying and selling securities as the result of movements in and out of the fund are externalized to the Authorized Participants.
The ETF structure also provides Authorized Participants and other large financial institutions the ability to engage in arbitrage and market making activities in ETF shares. Authorized Participants may buy or sell shares on the exchange, or also purchase or redeem shares directly from the ETF at the current value of the ETF's holdings. In the event that the trading price of an ETF's shares on an exchange drifts away from the current value of the ETF's holdings, an Authorized Participant can make a trading profit by exploiting such price differences. By engaging in such arbitrage and market making transactions throughout the trading day whenever an ETF's share price varies significantly from the value of its underlying holdings, the Authorized Participants quickly provide liquidity whenever there is an imbalance of buy or sell orders for ETF shares that may otherwise cause the shares to trade at a premium or discount. By supplying this liquidity, the Authorized Participants create tighter spreads in the marketplace and generally ensure that the exchange price generally tracks the value of the ETF's holdings closely, which benefits all investors.
But although there are a large number of ETFs that hold many different types of assets, the current ETF structure poses challenges in managing securities across certain asset classes, market segments, or in connection with other investment strategies (such as an actively managed investment strategy). This limitation is due to a variety of factors, including: (a) liquidity of the underlying assets or relevant market, (b) accessibility to the underlying assets or relevant market, (c) ability to create an effective tax management strategy, (d) transaction costs associated with the underlying assets or the relevant market, and (e) concerns regarding the transparency of portfolio holdings (e.g. in a non-passive investment strategy).
One reason for this limitation is the single basket structure of existing ETFs, which defines how shares of an ETF are created and redeemed. The list of all the component securities required to be delivered in connection with the issuance of shares of an ETF is commonly termed a “basket.” The basket for an ETF generally represents a proportional slice of the fund's holdings. In current ETFs, creation and redemption of shares are primarily made via an in-kind transfer of the securities held in the ETF according to the published basket. Existing ETFs thus use the same basket, published daily to the market, for creation and redemption of shares.
This single basket structure used for existing ETFs is limited, however, in that it requires the ETF's creation basket to consist solely of securities already held by the fund because only those securities are available for in-kind redemption. The single basket structure is also limited because it requires the ETF's redemption basket to consist of securities the ETF is willing to acquire, because the redemption basket is also the creation basket, rather than securities the ETF wishes to dispose. As a consequence of these limitations, existing ETFs generally must make changes to their portfolio by selling and purchasing securities in the secondary market, which imposes additional transaction costs on the ETF and detracts from the ETF's benchmark tracking and tax-efficiency.
These limitations also prevent the trading and management flexibility needed to address matters posed by asset classes or investment strategies involving less liquid, less accessible assets. Most existing ETFs invest in assets that are to some extent highly liquid and actively traded and therefore readily available in the market. For example, most ETFs track U.S. equity indexes comprised of stocks of companies that are normally highly liquid and readily accessible on a secondary market. Similarly, U.S. treasury bills, notes, and bonds are also generally liquid and accessible. In contrast, certain international and emerging market securities are not as generally liquid or accessible. In addition, certain fixed income securities are also not generally liquid or accessible, to the extent that different instruments issued by the same issuer generally have materially different terms, and similar instruments issued by different issuers generally have materially different credit risk.
Due to their lack of accessibility, transparency, and/or liquidity in the underlying market, certain types of assets are or may be difficult to hold in a traditional single basket ETF. This might be true for certain types of bonds, such as U.S. municipal bonds or non-US corporate bonds. Since the market for these types of bonds is generally less liquid than for U.S. taxable investment grade bonds, they may not be traded more than a few months after they are first issued. If a traditional single basket ETF structure were used for exposure to municipal bonds, an Authorized Participant would be unable to obtain all the required assets (e.g., the particular mix of municipal bonds contained within the ETF) to create shares of an ETF. Other types of illiquid or less accessible assets pose similar issues.
Accordingly, the limitations of traditional ETF structures create problems for effectively managing an ETF portfolio that comprises certain types of assets, including difficulties in tax management, benchmark tracking, fund compliance, and fund transaction cost management. Further, these problems transfer to the market makers trading the ETF in the primary and secondary markets in terms of their ability to buy in to and sell out of the deposit securities required for creating and redeeming the ETF as well as making cost effective markets.